If you’re currently in the process of rebuilding your credit, or don’t have any credit history to speak of, you may have come across or been pitched a “credit builder loan.”
These rather unique loans can work in different ways, but here’s the basic gist of it.
You apply for a small loan amount, typically something between $500 and $1000, though loan amounts can be as high as a few thousand dollars.
Once approved, the money is placed in an interest-bearing savings account with the lender, most likely a credit union. As opposed to receiving money and paying it back, you make payments and eventually gain access to the funds.
The loan will have an interest rate, such as 5% or 10% APR (or higher or lower) and a repayment period, typically 12 months.
Because the loan proceeds will be placed in savings account, it will also earn interest, albeit at a rate much lower than the interest rate on the loan.
How Does a Credit Builder Loan Work?
Let’s look at an example:
Loan amount: $1,000
Loan APR: 10%
Repayment period: 12 months
Monthly payment: $87.92
Total interest paid: $55.04
In this scenario, you’d make payments of $87.92 per month for one year to pay off the credit builder loan. That figure includes interest.
During the loan term, you’d pay a total of $55.04 in interest and $1,055.04 overall. However, some of that interest expense would be offset by the interest earned for keeping the money in a savings account.
Of course, the amount of interest you’d earn would likely be negligible, much like any other savings account earning far less than 1% these days.
However, what you’re really “paying for” is a better credit score. Or simply the establishment of a credit score if you’ve never had a credit card or loan to your name.
Each month as you make your payment, the issuer of the credit builder loan will report the payment activity to one or more of the three major credit reporting agencies.
As a result, you should see your credit score get established and/or improve. This in turn will allow you to apply for traditional loans and credit cards in the future.
For the record, secured credit cards accomplish the same basic thing, though they require collateral upfront.
Once the credit builder loan is paid off, you will have access to your original loan amount plus whatever interest was earned during the loan term.
Some of these loans allow you to access the money as it is paid off, whereas others require the loan be paid in full before you can touch the money.
Either way, it’s a kind of forced savings plan that also builds credit, so you can kill two birds with one stone.
Keep in mind that in order to get approved, you may need to provide income and employment documentation so the bank knows you’re good for the loan.
Tip: Watch out for credit builder loans that are riddled with fees and/or exorbitantly high interest rates. Shop around!
How Much Will My Credit Score Go Up?
There’s no definitive way of answering this question, seeing that everyone has a unique financial profile.
I’ve heard of some people seeing their credit scores rise 30-50 points, but again, it depends on where you started and what else is on your credit report.
If I had to throw out a number, something in the mid to higher 600s might be a good guess, but again, it can and will vary.
Just be sure your credit builder loan is actually reported to the credit bureaus. The more the better. Some credit unions may only report the loan to one of the bureaus. Try to find one that reports to two or all three.
That way you’ll have credit scores with each credit reporting agency, not just one or two.
Lastly, make sure you don’t pay late or miss a payment. The lender will report your payment activity to the credit bureaus whether it’s on time or late.
So these loans can actually hurt your credit score as well if you don’t make timely payments.
Read more: What credit score do you start with?